Thursday 1 March 2012

2012 Eurozone - For Now, A Normal Recession


The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

For more than a year now the world has worried that the Eurozone's financial problems are so extreme that they must inevitably drag the region into recession, and possibly much of the rest of the world with it.

Mainly these concerns are correct: the introduction of Euro-financing to countries who's productivity growth cannot begin to keep pace with German productivity growth has opened up huge gaps in competitiveness within the Eurozone which had been masked only by enormous build-ups of Eurozone debt. In the process, the nominal GDP of the weaker countries soared extraordinarily compared with the GDP of the core Eurozone countries, primarily Germany, and also compared to other developed economies. The chart below shows how it happened.
Now this debt financing is no longer available, and the underlying competitiveness issues widely understood, the Eurozone as currently constituted is living on borrowed time. By my calculations, even if labour productivity in the peripheral countries of the Eurozone had kept pace with Germany's, the scale of 'internal devaluations' needed in these countries to restore their intra-Eurozone competitiveness are simply impossible to achieve. Greece needs a devaluation of around 55%, Spain 50% and Ireland 45%. On the other hand, the scale of 'internal devaluation' needed by Portugal (18%) and Italy (10%) seem plausible.

Sooner or later, these devaluations will be made, either by massive and economy-shredding deflation in the peripheral countries (which surely could not be achieved without intense political disruption), serious and sustained inflation in the core countries (distinctly unwelcome to Germany), or through these countries accepting and external devaluation through exiting the Eurozone.

These choices seem obviously to most observers outside the Eurozone, but they currently elude the imaginations of Eurozone politicians and policymakers. And in the short-term, they continue to believe they are faced primarily with a liquidity problem (which can be resolved in the medium term by various 'rescue' expedients) whilst in the medium term the most visible aspect of the problem – the build-up of government debt – can be addressed by cutting public spending, closing fiscal deficits.

I expect they will continue to believe this even if Greece defaults and devalues later this year. Greece can yet be declared a 'special case', and the policy of liquefy the Eurozone banks whilst tightening the fiscal austerity screws will be maintained.

In the short term, it remains a reasonable expectation that continuing major infusions of extra liquidity can indeed prevent the underlying economic incompatibilities of the Eurozone from degenerating into uncontrollable financial crisis. For the ECB, even after taking into account the huge new lending of long-term money to Europe's banks at cheap rates (Eu489bn in three-year money in late December, with more to come later this year), still remains only modestly leveraged by central bank standards, with a total assets/equity leverage ratio of around 33x. That ratio could rise to around 45x before it would stand comparison with either the US Federal Reserve or the Bank of Japan.

But postponing financial catastrophe is not the same thing as fending off recession, and my three main cyclical indicators – return on capital, terms of trade, and leveraging trends - all point to recession in the Eurozone this year. There are three main indicators: return on capital is already falling; terms of trade have fallen back to 2008 levels and area likely to fall further if commodity prices continue rising; and bank deleveraging still has a long way to go. Beyond that, the ECB's new largesse is perversely also having the effect of accelerating the deleveraging process by making buying Eurozone sovereign bonds a much more attractive business for banks than the risky business of lending to the private sector.

By my estimate, the Eurozone had recovered about half the return on capital it lost during the financial crisis in 2008, unlike the US where the recovery was far quicker, and where ROCs are now at their highest level since 2000. Worse, it seems that ROC peaked in 3Q11 and almost certainly fell marginally again in 4Q11. When asset turns (sales/total assets) begin to fall one can expect investment spending to fall in sympathy – although this may be delayed by other factors which disguise or delay the underlying deterioration.
But there are only two disguises available in the medium term: either operating margins (indicated by international terms of trade) can rise, or financial leverage (indicated by bank loan/deposit ratios) can rise. Right now, neither of those tactics are available: whilst the Eurozone's terms of trade were steady throughout most of 2011, they are just about as bad as they were in 2008 at the height of the commodities boom. And whilst bank loan/deposit ratios have fallen consistently throughout the last five years, the fall has been so gentle it has merely allowed the ratio to drift down from a peak of 117% in 2007 to 104.4% now. Compare that to ratios elsewhere: 82% in the US; 96% in the UK; 68% in China and 70.6% in Japan and it is clear that the European banks still have a lot of deleveraging to do, and probably at a rather more rapid pace than during the past five years.
Indeed, one can see this more rapid pace emerging since December. Ironically, it is also hastened by ECB's determination to prop up Eurozone sovereign bond markets by making huge amounts of liquidity available to Europe's banks. The banks face a practical question: why take the risk of lending to the private sector when you have the choice both of taking the ECB's money and buying sovereign bonds, or alternatively, of simply putting the money back on deposit with ECB?

And that's what's happening: when ECB auctioned Eu 489bn of cheap three-year money in mid -December, the banks used that funding partly to lengthen their debt maturities, so the absolute rise in ECB lending came to only Eu214 billion. As more short-term debt has matured and not been replaced, the gross new lending has fallen to only Eu 122.25bn. Meanwhile, what have the banks done with the money? Overwhelmingly, they have re-deposited it back to the ECB: since mid-December, financial institutions' deposits with ECB have jumped by Eu307bn. In other words, the impact of the ECB's supply of cheap money to the Eurozone banking system has been, very perversely, to leave the ECB's net supply of credit to financial systems down by Eu 184.8 bn. In fact, the ECB's net supply of credit to financial institutions is now at its lowest point since the crisis began.

It is quite possible that in the next few months the ECB will become a net holder of deposits from Europe's banks. And, not surprisingly, at the same time, European bank lending, and European monetary aggregates are slowing very sharply.

In conclusion: the upside potential in Europe this year is limited to avoiding full-scale financial crisis. Even so, we should expect a year of unrelieved recession for the Eurozone as a whole, and on current policies there is no real reason not to expect this financial/economic stalemate to drag on throughout 2013 as well. Bond yields, naturally enough, are unlikely to rise. However, as precautionary savings ratios rise, we should expect the private sector savings surplus also to rise, which – if the Japanese example is anything to go by – also suggests we should not expect any collapse in the Euro (whatever this currency turns out to be).



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